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Today, with millions of people facing tremendous financial uncertainty related to the coronavirus, cash-out refinances could help homeowners fill in some of the financial blanks.
Traditional refinancing is what you do when you pay off an existing mortgage and replace it with a new home loan. For example, homeowners may refinance to take advantage of lower interest rates, to change the length of the loan or to swap an adjustable-rate mortgage for one with a fixed rate.
A cash-out refinance—often referred to as a “cash-out refi”—is different from a traditional refinance in that it replaces the old loan with a new one that is for an amount larger than the amount needed to pay off the old note. The difference between what was borrowed and what it takes to pay off the previous loan goes into the borrower’s pocket, no strings attached.
Cash-out refinancing has long been used by homeowners to raise money for things like paying for a child’s college education, funding a major home renovation or consolidating debt. When it comes to providing a potentially large sum of cash at an attractive interest rate with relatively easy qualification, cash-out refinancing is a tool with few peers in the realm of personal finance.
Wondering if you could do a cash-out refi? Black Knight, which tracks mortgage data, counted nearly 13 million homes that were strong candidates for refinancing in the middle of March 2020. This number, which is sensitive to changes in mortgage interest rates, was up 60% since the first of the year, according to an April 2020 Black Knight report on COVID-19’s impact on housing and mortgages.
As mortgage interest rates fluctuated in the early stages of the coronavirus breakout, the number of highly qualified refinance candidates fluctuated, but when rates were at their highest during the period, there were still more than 10 million high-quality refinance candidates, the company said.
All told, including those with mortgages that already have relatively low interest rates or are otherwise not prime refinancing candidates, there are approximately 45 million homeowners with more than $6 trillion in tappable equity available. That comes to $140,000 per homeowner, which should be enough to ride out even an extended COVID-19 downturn.
Of course, tapping this equity requires taking out a loan and shouldering possibly higher mortgage payments—although monthly payments could be lower if the cash-out refi also extends the term of the mortgage. And, as is the case with any loan, lenders want to see how borrowers will repay the loans. Even a laid-off or furloughed applicant might be able to show sufficient income from unemployment insurance payments or income from a rental property, although another option for an applicant without a job is to bring on a cosigner.
Cash-Out Refi Benefits
Cash-out refis offer significant advantages over other forms of financing, such as home equity loans or lines of credit. Borrowers usually can get a lower rate on a cash-out refi than on a home equity loan, for instance. That’s because a cash-out refi is a primary mortgage rather than a second mortgage, as is the case with a home equity loan, and this reduces risk for lenders.
Cash-out refis also are likely to be easier to get. The loans are more similar to purchase loans, which are the bread and butter of home mortgage lenders, than to home equity loans or home equity lines of credit. Because of that, more lenders are likely to offer them—with a significant caveat due to the fact that right now many mortgage companies are operating at reduced capacity because employees are working from home.
How to Get a Cash-Out Refi Loan
Getting a cash-out refi is similar to getting a mortgage to purchase a house. As with a purchase mortgage, the lender will look at the applicant’s income, other debts, credit score and employment history.
A cash-out refi also involves many of the same steps, processes, documents and costs. For instance, a cash-out refi borrower will often have to pay an application fee, origination fee, discount points, title search and insurance policy premium, as well as other fees for survey, appraisal and insurance.
There is one sizable difference between a cash-out refi and a purchase loan. That is, for the purchase of a home, many lenders will loan up to 97% of the price of the home. However, on a cash-out refi, an amount equal to 80% of the home’s value is as much as the borrower is likely to be able to get. The amount could be less, depending on the individual lender’s policies.
Buying a home can be as much an emotional decision as a financial one. A buyer who falls in love with a home may be willing to stretch financially in order to be able to live there, but a cash-out refi is more explicitly a dollars-and-cents decision.
You can take a closer look at the costs and benefits for your cash-out refi using an online calculator. The online refinance calculator at the National Bureau of Economic Research can help you figure out your optimal refinance rate, although the calculator at mortgagecalculator.org has more bells and whistles.
The first place to inquire about a cash-out refi is your current lender, but you also should shop around to get the best rate: Get quotes from at least three banks, credit unions or other mortgage lenders. Get a good-faith estimate from each one to compare terms and costs. Many of the costs are negotiable, and lenders’ offers vary widely. If one won’t give you the deal you want, another might.
Cash-Out Refi Limits, Risks and Costs
The main limit to a cash-out refi is that you have to have sufficient equity in your home. Remember that a lender probably won’t loan you more than 80% of the value of your home. You need to be able to get enough to pay off the current mortgage, plus have enough left over to cover all costs, while leaving you enough cash to have made the refinancing worthwhile.
For example, say your home is worth $300,000 and you owe $200,000 on the existing mortgage. You can get a refinance loan for up to 80% of the $300,000 value, or $240,000. Then say the closing costs come to $10,000. In this case, the amount of cash you can get is limited to $240,000, minus $200,000 to pay off your current loan, minus the $10,000 in costs for a net cash-out of $30,000.
The closing costs are a significant feature of a cash-out refi. Closing costs of 3% to 6% on a $300,000 loan come to $9,000 to $18,000. Closing costs on larger loans are likely to be on the lower end of that 3% to 6% range. Still, they’re not an insignificant cost.
Another potential cost that you didn’t encounter when making the purchase loan is a prepayment penalty. Some lenders require borrowers to pay this fee if they pay a loan off before its due date. Since you’ll be replacing your original loan with a new one, you may have to pay this fee.
Remember that the interest on mortgages—which is deductible only if you itemize—is deductible only when a mortgage is used to buy, build or make home improvements, not for other financial uses.
Doing a cash-out refi also limits how much you will get if you sell the property later on. Because you refinanced and traded the equity you had built up for cash, your share of the final sale proceeds after paying off the loan will be smaller.
Another thing to consider is that, as the years go by and you make the payments, a smaller percentage of your monthly mortgage payment goes toward interest. If you’ve been paying on the original loan for many years, after a cash-out refi, a much larger portion of the monthly payment will go for interest, rather than paying down the principal and building your equity.
And, just as your original purchase loan was secured by the home itself, your home will also serve as collateral on the cash-out refi loan. That means if you can’t make the payments, you risk foreclosure. For this reason, a cash-out refi probably is too risky if the new payments will be hard for you to make.
It’s also a good reason to be cautious about using a cash-out refi to replace unsecured debt, such as credit card debt. Even if the credit card debt is at a much higher interest rate, the credit card company can’t try to seize your home if you don’t pay the bill.
Cash-Out Refi Roundup
Cash-out refis earned a bad rap during the early years of this century. Back then, rising housing prices tempted many homeowners to essentially use their homes as giant ATMs. They employed cash-out refis in historically high numbers. Some experts say this overuse of cash-out refinancing, coupled with sloppy underwriting that led to a wave of borrower defaults, was the prime contributor to the ultimate housing collapse in 2008–2009.
After more than a decade of rising home values and much less use of cash-out refis, homeowners have much more equity in their homes than in 2008. However, it’s a good idea to keep in mind that ultimately a cash-out refi is a loan: It’s not free money, even if it’s low-cost money. The money borrowed against home equity will have to be paid back, either a month at a time or all at once when the borrower sells the home or refinances the loan.
The year of COVID-19, of course, is unlike any year most people can recall. Solving the problems presented by this episode calls for flexibility and resourcefulness. For those who can make the payments or find a cosigner and are able to use a cash-out refi, it could be a big part of the answer.